BREAKINGVIEWS – Pressure for sovereign CDS ban should be resisted

— The author is a Reuters Breakingviews columnist. The opinions expressed are his own —

By Neil Unmack

LONDON, Feb 17 (Reuters Breakingviews) – Every crisis needs a bogeyman. In a tense euro zone, attention is turning to sovereign credit-default swaps (CDS). Some in the market fear that regulators will now be tempted to ban these derivative instruments — just as the curbs on short-selling financial stocks were introduced following Lehman Brothers’ failure.

It is unclear whether such draconian moves really are in prospect, but wholesale curbs on sovereign CDS should certainly be resisted.

A sovereign CDS is effectively a tradable insurance policy against a country defaulting on its debt. Sky-rocketing sovereign CDS prices — caused by the market’s immaturity — can potentially spook investors in other markets and push up government bond yields, creating a negative feedback loop.

The fear is that this means rampant speculation using CDS can easily and needlessly exacerbate a country’s financing challenges.

It is true that CDS are more attractive tool for speculators than, say, equity short-selling. A CDS short-seller’s losses are limited, whereas the losses on a short equity position are potentially infinite if the stock rallies.

But an outright ban on sovereign is hard to justify, any more than banning any other derivative instrument. Sovereign CDS have legitimate uses in enabling banks and others to hedge their general exposure to a country. There’s no compelling evidence that CDS are actually inflaming sovereign debt worries. And while arguably safer than shorting stocks, CDS speculation can

still cost a trader his shirt.

Even if a ban were desirable, the side effects could be horrendous. Banks would need to use other ways to hedge country-specific risks, such as creating a short position in that country’s debt or shorting a relevant stock index. A ban might also remove potential demand for government debt from so-called negative basis traders, investors who buy bonds and short the associated CDS, pocketing the difference.

One idea doing the rounds is a half-way house — restricting sovereign CDS to those who already own the related government debt and therefore aren’t just speculating. But it is hard to see where a line should be drawn dividing legitimate and unlawful usage. Moreover, speculation can aid price discovery when markets aren’t functioning well.

A better way forward would be to improve disclosure. Daily information on traded volumes — as opposed to the current weekly updates — would give outsiders a better sense of the market’s true activity. Ensuring contracts go through a clearing house would address fears about counterparty risks. But full-blown market curbs could backfire badly.